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Why Do Companies Issue Convertible Debentures

18 Aug 2023

Debentures are a type of debt instrument companies use to raise funds from the market. When you invest in a debenture, you earn an interest at a predetermined maturity date. Companies issue debentures to raise capital for multiple functions, such as expanding their operations, investing in new projects, acquiring assets, or simply fulfilling their working capital requirements.

Different debentures include convertible, non-convertible, registered, unregistered, redeemable, and irredeemable. This article will help you understand more about convertible debentures and why companies issue them.

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What are convertible debentures?

Convertible debentures are a specific type of long-term debt instrument companies employ to raise capital. These debentures are usually unsecured and possess a unique attribute. They can be converted into company stock after a predetermined timeframe. 

Tangible assets are back convertible debentures. They derive value from their dual nature of offering fixed-income returns coupled with the possibility of equity ownership in the company. For you as an investor, this translates into an investment avenue that balances the stability of debt instruments with the potential for increased returns through equity conversion at maturity.

In most cases, you can decide to convert your debentures into shares and capitalize on the company's growth prospects. However, the companies may also choose to do so in some cases.

Types of convertible debentures

Understanding the types of convertible debentures is essential to make informed investment decisions. Primarily, convertible debentures can be categorized into the following:

  • Fully convertible debenture

In the case of fully convertible debentures, the entire value of the debentures can be converted into equity shares of the company. In simpler terms, if you hold fully convertible debentures, you can exchange the complete value of your debentures for shares of the company's stock.

  • Partly convertible debenture

In contrast, partly convertible debentures offer the option to convert only a portion of the debentures you hold. The remainder of the debentures retains their status as debt instruments, earning you fixed interest income over time. This structure allows you to strike a balance between the stability of fixed returns and the potential for equity ownership.

Why do companies issue convertible debentures? 

Convertible debentures have a distinctive feature. Instead of just getting your money back with interest at maturity, you can also get company shares. This way, you become a part-owner of the company. While this can offer you advantages, it also benefits the company. For the company, convertible debentures provide an opportunity to acquire funds to grow. Moreover, they can decide whether to pay you back in money or shares.

When traditional debentures are due for repayment, the company must repay all lenders in cash. But with convertible debentures, the company does not need to pay as much if some lenders prefer shares instead of cash. This can be a real advantage and help companies save money.

However, if too many lenders choose to convert their debentures to shares, it could thin the company's ownership and impact its stock value. Therefore, companies need to strike a balance and be careful when choosing a method to redeem debentures.

What are the benefits of convertible debentures for investors?

You will incur a loss if the company fails to repay the loan. However, you can get a stake in the company's growth with convertible debentures. As an investor, you benefit from interest payments and an opportunity to join in the company's success. 

However, monitoring the company's growth and making rational investment decisions is essential. Not all stocks offer the potential to grow. Therefore, before converting your debentures to shares, you must focus on factors like the company's performance, sector and industry-specific growth, market trends, and more.

To sum it up

Convertible debentures stand as a unique bridge between debt and equity. They offer you the potential for stable returns and an opportunity to become part-owners of the issuing company. They also provide companies with the advantage of lowered redemption costs and a flexible avenue to secure funds for growth.

However, as with any investment, you must be careful of market trends, company performance, and growth prospects to make informed decisions about converting debentures to shares.

Unlock opportunities in non-convertible debentures by opening a free Demat account with Motilal Oswal.

 

Related Blogs: How Is Redemption of Debentures Calculated | Difference Between ROIC and ROCE | Why companies that reduce debt outshine the market | What Us The Rule of 72

 

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